About 10 years ago, I began a daily habit of logging on to the US Tax Court website at 3pm and looking for that day's Tax Court decisions. ๐ I look every weekday whether I'm traveling, on vacation, or deep in busy season. It's wild the amount of tax alpha (and tea ๐ต) that gets posted for free. ๐ After a while, some recurring themes standout - tax positions that get challenged consistently. And the best ones are when the IRS loses their case and the taxpayer wins. Today, we're looking at 5 areas that are most challenged in Tax Court ๐จโโ๏ธ - and how to use these grey areas in your tax situation:
Before getting into it, I also run the Today in Tax Court podcast that breaks down a lot of these lessons. The most popular episode is the recap of the 2024 top cases. You can find it on Spotify, Apple Podcasts, etc:
Okay, let's dig in: Character of Income or LossNot all income and loss is treated the same on your tax return. There are a few different ways to classify income and loss but the biggest tax impact are when the character is between:
Whether an income event is capital or ordinary really depends on the underlying nature of what happened. ๐คทโโ๏ธ The main point here is the intent of the seller. For example - an investor who buys one home, holds it for rent, then sells it 3 years later is a VERY DIFFERENT fact patter than someone who buys 100 homes and sells them immediately. The goal is to structure around the intent and bifurcate between them. A Bramblett Transaction is a great example of structuring around intent. ๐ง In short, it breaks out a real estate developer's land banking intent from the development intent. And when done right can shift substantial gain on the sale of the buildings from ordinary (development income) to capital gain (appreciation of the land). Active versus passive is relatively newer - as we were gifted the passive loss limitations in 1986 tax reform. Before then, income and losses could be lumped into one bucket relatively simply - so an investment loss could offset your W2 (effectively buying tax savings without much risk). But now, the Court looks at level of involvement in an activity to see if it's eligible for Active treatment (and can offset your W2). The override to the limitation are elections - specifically the ยง469 elections. ๐ฎ In these, a taxpayer can claim various activities (subject to rules) are all treated as "one activity" for the purpose of Active vs. Passive. TimingA nuance of our progressive tax system (tax brackets) is that timing of income or loss can have a huge impact on the tax bill. โ๏ธ For example, if I sell my business for $10 million in one year, I will pay tax at a higher rate than in the following year when my income is far lower. So to combat this, I want to use as much deduction as possible in the high tax year compared to the lower one. Accordingly, a common issue in Tax Court is taxpayers arguing which period income or loss really occurred. This has led to various decisions defining when a taxpayer has "control" over an "accession to wealth." The lessons consistently learned here are to plan ahead for major tax events and keep good documentation. ๐ญ DocumentationSpeaking of, so many small businesses that end up in Tax Court are there because their deductions are being challenged. There is a special rule called the Cohan Rule that allows the Court to infer deductions necessary to the business - so even if no receipts or accounting reports are available, deductions could still be allowed. ๐งพ But you don't want to rely on this rule - as it's not always taxpayer favorable (usually it's some % of claimed deductions). But some deductions are exempt from this rule and require ADDITIONAL DOCUMENTATION in the form of receipts and logs (concurrent notes of time, description, and business purpose). These scrutinized deductions are things like meals, travel, lodging, mileage, etc. โ๏ธ Things that could be personal in nature require more intention in documenting. AssignmentQuestions of "whose income is it anyway" have been going on for as long as we've had our current tax system. Because of our tax brackets, and difference in tax rates between entity types (C-Corp versus Personal), many taxpayers will argue that some portion of gain (or loss) is really attributable to other entities. ๐ The Court usually challenges these if they are "overly tax-convenient" but many actually hold up. A popular assignment argument is the concept of "personal goodwill." Personal goodwill is when income from a sale that usually happens inside a C-Corp is attributed in part to a shareholder. That portion of the sale is treated as capital gain and taxed at a single-layer instead of being double-taxed inside the C-Corp and again when a dividend is taken. ๐ฐ ValuationTwo areas where we see valuation argued consistently:
The IRS goes after gifting valuations because they want gift tax (currently a flat 40% tax rate). โ ๏ธ So they hone in especially on small businesses or other items gifted that are more subjective. But if a good valuation expert is used and all required filings are made, this is a place were the IRS can often lose. Charitable donations are the opposite - the IRS wants to argue that what was gifted was either (1) less valuable than claimed, or (2) not really given up in full. The lessons here are to use a qualified valuation specialist and make all your requisite filings - but don't be afraid to fight back. ๐ฅ โ The single best lesson I've learned in reading daily Tax Court cases is that no one ever really wins going to Tax Court. It often opens your business and personal life up to unnecessary scrutiny and nosy people (including yours truly). ๐ซก ๐จIf you enjoyed the tax strategies - consider supporting the newsletter by visiting my Products. I have accounting checklists, tax strategies detailed, and other helpful downloads I'll be adding to. This week I'm featuring the Life Plan of Tax download. It's ideal for someone looking for creative but realistic tax ideas, or a CPA looking for a starting point to sell more work. It includes the 7 Foundations of Tax Strategy + 10 detailed calculations of things like the ยง469 election mentioned above: Other strategies included in 20 pages: Step-up in Basis, Reverse Cost Segregation, 163j RPTOB election, Deferred Acquisition Fees, etc. Get it here ๐ ๐ฅ Hottest Finance Posts This Week ๐ฅโ
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